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Series of criminal securities prosecutions collapse when Second Circuit rules that 10b-5 violation requires an act that conveys a false impression

The Second Circuit Court of Appeals affirmed the acquittal of David Finnerty, an NYSE specialist criminally indicted for allegedly engaging in interpositioning. (According to the Court, interpositioning occurs when a specialist “acts as an arbitrager by taking a profit [for his firm and himself via compensation] on the spread between the bid price and the ask price of customers’ orders.”) The Court found that the government did not prove that Finnerty’s conduct was deceptive under federal securities laws because it did not present any evidence that Finnerty communicated anything at all to his customers and certainly not anything false. This decision raises a key issue as to whether this holding applies only to the unique role of specialists or has broader applicability to the securities industry.

Prior to the NYSE’s recent changes to the role of specialists, each security traded on the NYSE was assigned to a particular specialist firm and bids to buy and offers to sell a security had to be presented to the firm to which the security was assigned. In addition to placing these orders, a specialist executed trades for his firm’s account. Each specialist firm had a computerized display book which allowed the firm to execute orders.

In 2006, Finnerty was charged in the Southern District of New York with several counts of securities fraud, including an allegation that, while he was employed by Fleet Specialists, Inc. from 1999 to 2003, he engaged in 26,300 acts of interpositioning resulting in illegal profits to his firm’s account of approximately $4.5 million. While the jury entered a guilty verdict against Finnerty, the district court granted Finnerty’s post-trial motion for judgment of acquittal because the government did not provide evidence of customer expectations to demonstrate deception under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. §78j (“Section 10(b)”) or Rule 10b-5, 17 C.F.R. § 240.10b-5. The government appealed.

In United States v. Finnerty, the Second Circuit reviewed the judgment of acquittal de novo and considered whether Finnerty said or did anything deceptive. The government admitted that Finnerty made no misstatement, and argued instead that he engaged in “non-verbal deceptive conduct.” Referring to the recent U.S. Supreme Court case, Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, the Court acknowledged that conduct alone can be deceptive and evidence of a specific oral or written statement is not necessary. However, the Court found that there must be an “act that gives the victim a false impression.” The Court concluded that the government did not present any evidence that Finnerty communicated anything at all to his customers and certainly not anything false, and that “the government undertook to prove no more than garden variety conversion.” Relying upon Stoneridge, the Court reasoned that finding Finnerty liable for securities fraud without evidence that he conveyed a misleading impression to customers raised the risk that federal power would encroach upon areas already protected by state law. The Court rejected the government’s argument that, because some customers may have known that NYSE rules do not allow a specialist to engage in interpositioning, that amounted to an assurance against interpositioning. The Court reasoned that unless the customers’ understanding was based upon conduct by Finnerty, he did not commit a primary violation of Section 10(b). The government argued that there was evidence which, when viewed in the light most favorable to the government, demonstrated that Finnerty knew he had violated an NYSE rule and tried to cover it up, but the Court found that “violation of an NYSE rule does not establish securities fraud in the civil context, let alone in a criminal prosecution.” For these reasons, the Court affirmed the judgment of acquittal.

A few weeks after this decision, in United States v. Hayward, the Court relied upon the rationale of Finnerty and reversed the conviction of two specialists, Michael Hayward and Michael Stern, because the evidence presented was insufficient to prove deception. Similarly, in the aftermath of Finnerty, a federal judge vacated the guilty pleas of two specialists, formerly of Van der Moolen Specialists USA LLC; and prosecutors dropped the criminal case against another specialist, formerly of LaBranche & Co. LLC.

Last month, the district court for the Southern District of New York (the “district court”) issued an opinion which included an analysis of the rationale expressed in Finnerty outside the specialist context. In SEC v. Simpson Capital Management, Inc. an investment adviser and some of its principals were charged with using broker-dealers to engage in late trading. The district court distinguished the facts in Finnerty from those in Simpson. The district court reasoned that Finnerty did not engage in deception because he did not mislead buyers or sellers about the prices and terms of their trades; however, it found that the Simpson defendants clearly engaged in deception because they misled mutual funds into believing that trades were made before 4 p.m. when they were actually submitted much later and with the benefit of additional information. The district court denied defendants’ motion to dismiss the complaint.

The fact that in Simpson the district court considered the rationale expressed in Finnerty and applied it to a fact pattern involving an investment adviser suggests that such a rationale is not restricted to specialists and may remain relevant despite the diminishing role of specialists. However, the fact that the defendants in Simpson could not escape liability for securities fraud under the rationale of Finnerty because they engaged in an act that clearly conveyed a misleading impression suggests that the universe of defendants able to seek protection under the rationale of Finnerty is limited.

The full text of the Second Circuit decision is available at United States v. Finnerty, 533 F.3d 143 (2d Cir. 2008). The full text of Stoneridge is available at Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 128 S.Ct. 761 (2008) and the full text of Simpson is available at SEC v. Simpson Capital Management, Inc., U.S. Dist. LEXIS 67054 (S.D.N.Y. Sep. 03, 2008).

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